Stocks of aluminium registered with the London Metal Exchange (LME), for example, have fallen by 577,275 tonnes, or almost 20 percent, so far this year.

And although the price of London aluminium has risen 8.6 percent so far this year to a current $1,600 per tonne, no-one is getting too excited.

The median expectation is for the price to still be around that level in the fourth quarter of this year, according to the latest quarterly Reuters poll of analysts.

Disappearing LME stocks are no indicator of physical market balance with a median expectation of a global 267,500-tonne surplus this year.

Rather, the slide in registered inventory reflects the LME's own delivery mechanics, specifically the exchange's accelerated load-out requirements for aluminium stuck in a queue at the Dutch port of Vlissingen.

And something similar is happening in the Shanghai aluminium market, where stocks have fallen even more sharply and the price has outperformed London with a year-to-date gain of over 15 percent.

In the case of the Shanghai Futures Exchange (ShFE), though, the problem with its delivery function is not too much metal waiting to get out of warehouse but too little available for delivery into warehouse.

STOCKS CRUNCH

Registered inventory on the ShFE stood at 133,602 tonnes, effective the weekly report issued on Friday, July 22.

Stocks have fallen by 163,435 tonnes, or 55 percent, since the start of January. They are currently at their lowest level since November 2011, when the ShFE aluminium contract was still in its relative infancy.

Aluminium volumes in 2011 totalled 19.9 million lots, a level of activity that was matched in the first three months of 2016 alone.

Rising activity should, all other things being equal, suck in stocks liquidity. That has been the case with the Shanghai nickel contract, where turnover regularly exceeds that on the London market and which has accordingly seen a dramatic flow of physical metal, over 100,000 tonnes, into ShFE warehouses in the first year of trading.

The temptation is to conclude that the combination of higher Shanghai aluminium trading volumes and chronically low inventory cover must be a sign of domestic market deficit.

Particularly, when China is widely held still to be a core driver of global aluminium usage. Indeed, Norway's Norsk Hydro has just revised upwards its Chinese demand growth forecast for this year to 5-7 percent from a previous 3.5 percent. nL8N1A70LE

HOT OR COLD?

However, the truth is that the ShFE, like its London peer, is also experiencing structural issues with its physical delivery function.

ShFE allows for the delivery of physical aluminium in 25-kg ingot form, its specifications tailored to match those on the LME.

The only problem is that fewer and fewer Chinese smelters are producing ingot, or any sort of aluminium, in cold form.

There has been an accelerating shift towards transferring metal in hot molten form to the customer for further working.

This is a far more efficient distribution system, since the first thing a caster of cold ingot does it to remelt it before transforming it into a semi-fabricated product. Receiving molten rather than cold metal cuts both time and cost.

China's aluminium industry has been quick to grasp the savings of such a system to the point that consultancy AZ China estimates that around two-thirds of all Chinese aluminium production is now being moved in molten form.

This evidently means far less cold metal available for delivery against the ShFE contract.

The sharp decline in ShFE stocks this year reflects primarily a shortage of available deliverable cold aluminium, not a shortage of aluminium.

After all, the Chinese market still shows every sign of being in supply-demand surplus, witness the still super-strong flow of exports of semi-manufactured products out of the country, 2.0 million tonnes of them in the first six months of the year.

COOLING INTEREST

So just how low can ShFE stocks go before something changes? Given how low they already are, the consensus thinking is not much further.

There are two obvious ways for the downtrend to correct.

The first is for Chinese smelters to shift production back to cold metal in response to emerging tightness on the Shanghai market.

They have no obvious price incentive to do so, since they are all to varying degrees reaping the benefits of the out-performance of the Shanghai contract.

However, if consumer demand cools, there's not much point in shipping out molten metal if there's no customer there to receive it in that form.

This may already be starting to happen, according to AZ China, citing the normal seasonal lull in activity over the northern hemisphere summer months.

The second is for non-Chinese producers to deliver metal into the Shanghai market. Only two have the potential to do so: Rusal and Alcoa.

The ShFE aluminium contract has two deliverable Russian brands, from Rusal's Irkutsk and Sayanogorsk smelters, and one Alcoa brand, from its Portland smelter in Australia.

The latest trade figures showed no significant increase in imports from either country, suggesting that this emergency brake on falling stocks has yet to kick in.

TIGHTNESS IN LONDON, TIGHTNESS IN SHANGHAI

Until the stocks trend corrects, however, the Shanghai aluminium contract will remain tight.

The market's forward curve through to February next year is currently backwardated with nearby prices commanding a premium over further-dated prices.

As such, it is mirroring the London market, where spreads are also showing signs of structural tightness thanks to all that metal leaving daily and the resulting squeeze on tonnage available for position settlement.

The benchmark LME cash-to-three-months spread CMAL0-3 is not currently in backwardation but at a $10 contango is tight enough to be causing problems for stocks financiers, as shown by the recent deliveries of metal into LME sheds in Asia.

It's ironic that both exchanges are signalling tightness in a market still widely believed to be both over-supplied and carrying high, but increasingly less visible, inventory.

Ironic and dangerous, since higher prices and tighter spread structures will only encourage more smelters, particularly Chinese smelters, to restart mothballed capacity.

Just don't expect them to pour too much cold metal over an overheating Shanghai aluminium market. (Editing by William Hardy)